7 Lecture 7(I): Exchange rate overshooting - Dornbusch model

Reference: Krugman-Obstfeld, p. 356-365

7.1 Assumptions: prices sticky in SR, but flex in MR, endogenous expectations

Clearly it applies only to flexible exchange rates as, under a credible fixed exchange rate
regime, expectations are actually exogenous; i.e. ∆ee = 0.
Main differences from Mundell-Fleming:
• Both short run and long run within the same model. Prices are sticky in the short run,
but flexible in the long run.

• Expectations are endogenous.

• So, you should expect similar results to Mundell-Fleming. Monetary but not fiscal policy
affects the level of output under flexible exchange rate.

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 7.1 Assumptions: prices sticky in SR, but flex in MR, endogenous expectations

• Expectations are formed rationally; i.e. Etet+1 = et+1 or ∆eet+1 = ∆et+1.

• We restrict attention to a simple case: prices are fixed for one period. Namely: Prices
are fixed at p̄ in period t but are fully flexible from period t+1 onwards.

• We write the model in logs and assume for simplicity that aggregate expenditure does not
depent on the the interest rate and money demand depends on the medium run equilibrium
level of output not its current level.

• Restrict attention to equilibria in which all exogenous variables grow at a constant (possibly
zero) rate.

• Initially the economy is in equilibrium with full employment output (i.e. price is the same
as in flexible price equilibrium).

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 7.1 Assumptions: prices sticky in SR, but flex in MR, endogenous expectations

IS: yt = z̄ + η(et + p∗t − pt) (108)

LM: mt − pt = ȳ − it (109)

UIP: it = i∗t + ∆et+1 (110)

Constant money growth: mt+1 − mt = µ (111)

Period 1 AS: p1 = p̄ (112)

Period t > 1 AS: yt = ȳ. (113)

Note that p̄ is at level that would prevail under flexible prices in the absence
of any policy change. (i.e. economy is initially in MR equilibrium).

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 7.2 Solving backwards from period 2 (flexible prices).

7.2 Solving backwards from period 2 (flexible prices).

AS is given by equation (113). Replacing into IS

ȳ − z̄
et + p∗t − pt = , for all t ≥ 2. (114)
η

Real exchange rate determined by goods + labour market. Constant at all future periods
(relative PPP holds). Hence, (114) and (111) imply

∗ ∗
∆et+1 = πt+1 − πt+1 = µ − πt+1 , for all t ≥ 2. (115)

Replacing into LM using UIP

mt − pt = ȳ − (i∗t − πt+1
∗
+µ), for all t ≥ 2. (116)
| {z }
rt∗

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 7.2 Solving backwards from period 2 (flexible prices).

Hence, for all t ≥ 2, et and pt are determined by the following system of equations

ȳ − z̄
et + p∗t − pt = , (117)
η
mt − pt = ȳ − (rt∗ + µ) (118)
• Fiscal expansion (higher z̄) results in appreciation of the real exchange but unchanged pt.
So, all the adjustment in the real exchange rate takes place through appreciation of et
(same as flex price Mundell-Fleming).

• Expansionary monetary policy shock (e.g. higher mt or µ) results in higher pt but un-
changed real exchange rate (money neutrality). Nominal exchange rate adjusts one to one
to keep real one unchanged (same as flex price Mundell-Fleming or monetary model).

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 7.3 Solving for period 1: fixed prices

7.3 Solving for period 1: fixed prices

Replacing using (112) into (109)

LM: m1 − p̄ = ȳ − (i∗1 + e2 − e1) (119)

IS: y1 = z̄ + η(e1 + p∗1 − p̄). (120)

(121)

With e2 given from flexible price equilibrium in period 2, LM curve determines e1 and then
IS determines y1.

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 7.3 Solving for period 1: fixed prices

Goods market shocks. Consider a permanent, one-off, increase in government expenditure

(i.e. z̄ to z̄ 0 > z̄). Figure on following page illustrates graphically.

• In period 2 the real exchange rate rert = (et + p∗t − pt) has to be lower to crowd out foreign
demand for home goods and ensure goods market equilibrium given ȳ.

• Since the shock does not affect the money market, p2 is unchanged at its initial equilibrium
p̄. So change in rer is fully reflected in appreciation of e2.

• At time 1, given that there is no change in m1 and p1 is given, e2 − e1 has to equal zero
for the money market to be in equilibrium (i.e. nominal interest rate not to change).

• Since e2 − e1 = 0, e1 has to jump to its MR equilibrium value e2 and then stay constant.
As in Mundell-Fleming: no effect on output.

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 7.3 Solving for period 1: fixed prices

et

0 1 2 3 4 5 ... t
pt

p̄

0 1 2 3 4 5 ... t
et + p∗t − pt

0 1 2 3 4 5 ... t

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 7.3 Solving for period 1: fixed prices

Money market shock. Consider a permanent, one-off, increase in the money supply mt.
Figure on following page illustrates graphically.

• From period 2 onwards, the real exchange rate is unchanged as the shock is not real.

• Yet, pt has to increase from t = 2 onwards to keep money market equilibrium. Hence, et
has to increase one-to-one from t = 2 onwards to keep rer unchanged.

• At time t = 1, though, p1 cannot adjust to clear the money market. Since real money
supply is higher, the nominal interest rate i∗1 + e2 − e1 has to fall for money demand to
increase and reestablish money market equilibrium. So e2 − e1 has to fall from zero (before
the shock) to a negative number to reduce the interest rate while ensuring no arbitrage.

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 7.3 Solving for period 1: fixed prices

et

0 1 2 3 4 5 ... t
pt

p̄

et + p∗t − pt 0 1 2 3 4 5 ... t

0 1 2 3 4 5 ... t

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 7.3 Solving for period 1: fixed prices

• The only way i1 can fall below i∗1 to ensure money market clearing is if the exchange rate
is expected to appreciate between 1 and 2. But we know that at 2 the exchange rate has
to be higher than it was before the monetary shock. So, the only way it can appreciate
between 1 and 2 is if immediately after the shock it jumps above (overshoots) its new long
run value e2.

• Note that with given prices at time t also the real exchange rate overshoots its long run
value and output is temporarily above full employment.

• The model is able to capture excessive fluctuation (overshooting) of nominal and real
exchange rates and the fact that monetary expansions and exchange rate depreciations are
associated with falls in interest rates .

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8 Lecture 7(I): Speculative attacks on fixed exchange rate

8.1 The central bank balance sheet

Please refer to chapter 17 in Krugman and Obstfeld.

Assets Liabilities

D Home assets Bank deposits 
H
R Foreign asset reserves Notes and coins 

Assume for simplicity the money supply multiplier is one; i.e. M = H. So, the money
supply at time t is given by Mt = Dt + Rt. The central bank (CB) can alter the money supply
M by buying/selling either home assets (altering domestic credit D) or foreign reserves R.
∆M = ∆D + ∆R.

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 8.1 The central bank balance sheet

Sterilized versus unsterilized intervention on the foreign exchange market:

• Unsterilized: CB buys/sells reserves and lets the money supply change accordingly; i.e.
∆M = ∆R.

• Sterilized: CB buys/sells reserves but conducts offsetting open market operations in home
assets to keep the money supply unchanged; i.e. ∆D + ∆R = 0.

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 8.1 The central bank balance sheet

All the models of the exchange rate we have studied imply that sterilized intervention cannot
affect the exchange rate. What matters is the money supply Mt not its composition6.
For example, the (modern) monetary model under constant money growth implies

et = f unt + α∆et+1 (122)

∗
∆et+1 = ∆mt+1 − πt+1 . (123)

with f unt = (mt − m∗t ) − (ȳ − ȳ ∗).

6
There is one caveat to this statement which goes under the name of the signalling hypothesis. Sterilized intervetion can affect the current exchange
rate if it alters expectations about future fundamentals (hence it affects ∆et+1 ).

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 8.1 The central bank balance sheet

This result is common to any model of the exchange rate in which home and foreign assets are
assumed to be perfect substitutes up to an exogenous risk premium. In these models changes
in portfolio composition do not affect risk or returns.

Corollary 1 A country can set any level it wants for et independently from whether it
has or not enough reserve. If it has no reserves all it has to do is to set the right money
supply by altering domestic credit.

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